New naked short selling rules could improve enhance market efficiency

by Ray PerrymanMidland Reporter-Telegram

Published 7:00 pm, Saturday, September 12, 2009

I'm a firm believer in the power of markets. However, there are times when they require parameters to keep them functioning properly. Well constructed regulations can enhance operations, increase efficiency, and improve general effectiveness. In the case of the recent implementation by the Security and Exchange Commission (SEC) Division of Enforcement of new rules pertaining to a select aspect of market activity — naked short selling — the potential for fulfilling these objectives is certainly present.

The rules change follows a significant number of complaints over the past several years from both investors and issuers of securities that the practice of naked short selling, if abused, could be detrimental to the market. In light of such possibilities, various groups have contended that the SEC enforcement arm has been negligent in addressing the matter, at least up until a few weeks ago.

Basically, a short sale involves selling a stock that the seller does not yet own or will borrow for delivery at some date in the future. Those who short sell are often seeking to either hedge against future price volatility in stocks they control or profit from a belief that the price of the stock will fall. If the price does fall, short sellers buy shares in the market at lower prices to fulfill their sales agreement, thus making a profit. Of course, if the price rises, the seller incurs a loss. This practice is not illegal and has been a part of market trading for some time, though not without controversy.

In a "naked" short sale, however, the underlying stock hasn't even been borrowed, and market analysts argue that this allows market manipulators to artificially drive down prices. Abuses in short selling occur when short sellers fail to borrow and deliver securities to the buyer within the standard four-day timeframe. Federal securities laws forbid abusing or manipulating naked short selling in order to drive down the stock price, but enforcement has been difficult. Through the years, there have been numerous complaints alleging the loss of substantial sums because the SEC had not taken sufficient action to control such a practice.

The SEC did implement a short sale regulation in 2004, but little attention was paid to it over the years. The financial challenges the nation has been experiencing since December 2007 brought renewed interest by the public and led to charges that the practice played a significant role in exacerbating the crisis

As a result, the SEC instituted emergency rules forbidding short selling of stock in various financial institutions. This later was expanded to the securities of all public companies. In addition, adjustments were made in established procedures in an attempt to prevent abusive short selling and, hopefully, restore investor confidence in the market.

Violations of these requirements could lead to varying degrees of prohibition of further short sales in the same security or by the same customers. More severe penalties were authorized for short sellers who engage in deliberate deception of broker-dealers or other market participants.

Because of the possible disruptions to the securities markets that could be caused by reckless short selling and the potential for a drop in the overall confidence in the markets which could lead to panic selling, the SEC recently issued new rules to govern all such operations. Now, short sellers are required to complete the trade within four days or become subject to penalties. In addition, specific information about short-sale trades will be published (on a one-month delay) to enable investors and analysts to identify instances of improper coordination.

In introducing these regulations that call for greater transparency and the dissemination of significantly more information about the volume and velocity of sales, the SEC remains committed to ensuring that trading secrets are preserved and money manager positions remain confidential. However, the potential for abuse will be greatly reduced, and timely and accurate information always makes markets more efficient.

Hopefully, as the SEC strives to overhaul additional financial regulations in the future, damaging practices can be minimized and appreciation and confidence in market operations will be strengthened. There is always a danger of overkill, which can be counterproductive, but constraints are essential in certain areas.

Dr. M. Ray Perryman is President and Chief Executive Officer of The Perryman Group (www.perrymangroup.com). He also serves as Institute Distinguished Professor of Economic Theory and Method at the International Institute for Advanced Studies.